Macroeconomics

The Determination of Residential Investment

The relative price of housing

adjusts to equilibrate supply and demand for the existing stock of housing cap-

ital. The relative price then determines residential investment, the flow of new

housing that construction firms build.

F I G U R E

1 8 - 5

Stock of housing capital, K

H

Flow of residential investment, I

H

Supply

Demand

Supply

Relative

price of 

housing, P

H

/P

P

H

/P

(b) The Supply of New Housing

(a) The Market for Housing

---

price. Panel (b) shows that the increase in the housing price increases residen-

tial investment.

One important determinant of housing demand is the real interest rate. Many

people take out loans—mortgages—to buy their homes; the interest rate is the

cost of the loan. Even the few people who do not have to borrow to purchase a

home will respond to the interest rate, because the interest rate is the opportu-

nity cost of holding their wealth in housing rather than putting it in a bank. A

reduction in the interest rate therefore raises housing demand, housing prices,

and residential investment.

Another important determinant of housing demand is credit availability.

When it is easy to get a loan, more households buy their own homes, and they

buy larger ones than they otherwise might, thus increasing the demand for

housing. When credit conditions become tight, fewer people buy their own

homes or trade up to larger ones, and the demand for housing falls.

An example of this phenomenon occurred during the first decade of the

2000s. Early in this decade, interest rates were low, and mortgages were easy to

come by. Many households with questionable credit histories—called subprime

borrowers—were able to get mortgages with small down payments. Not surpris-

ingly, the housing market boomed. Housing prices rose, and residential investment

was strong. A few years later, however, it became clear that the situation had got-

ten out of hand, as many of these subprime borrowers could not keep up with

their mortgage payments. When interest rates rose and credit conditions tight-

ened, housing demand and housing prices started to fall. Figure 18-7 illustrates

the movement of housing prices and housing starts during this period. When the

housing market turned down in 2007 and 2008, the result was a significant down-

turn in the overall economy, which is discussed in a Case Study in Chapter 11.

C H A P T E R   1 8

Investment

| 541